When The Betting on QE Suddenly Goes Wrong
"As we can see with the bull market in China, once a bubble forms it has an internal logic of its own and it will grow until it has outgrown all of its surroundings," wrote hedge fund manager Crispin Odey in a letter to his investors on May 28, after a fund in his $12.9-billion Odey Asset Management company had lost a breath-taking 19.3% in April alone and was down 18.2% year-to-date.
April was "bloody," he wrote. Negative interest rates in Europe had created a bubble that would end "badly." He'd been caught on the wrong side on multiple levels:
In hindsight the tail wind that was the leveraged position in the US dollar against Emerging Market currencies in particular, meant that I did not respond quickly enough to the aggressive QE introduced by Draghi in December of last year and the effects of the fall in the oil price two months earlier.
He wasn't alone. Other bets that had worked for so long suddenly went wrong too.
Andrea Giannotta's €3.7-billion long-term euro fund at Eurizon Capital had been up 6.7% in the first quarter, benefiting from the surge of long-term bonds as the ECB's QE pushed down yields. But when the selloff hit, these bonds got whacked and have since given up nearly all of their gains. He expected yields to continue to go up, he told theWall Street Journal. So there would be more pain.
"Fixed income had a great ride for a long time, but in the last few weeks we have lost a lot of money," explained Tanguy Le Saout, head of European fixed income at Pioneer Investments. Their €4.9-billion aggregate bond fund lost enough money in April to wipe out most of the 3.1% gain in the first quarter. "People expect fixed-income funds to have a positive return, and the recent selloff is questioning that," he said.
Euro bonds had surged for years as hedge funds had been front-running the ECB's long-rumored QE that was finally announced as a €60-billion-a-month bond-buying program in January and implemented in March. They rode it up, driving bond prices to ludicrous levels, pushing yields of many government bonds below zero.
But just as ECB President Mario Draghi was declaring victory over we still don't know what in mid-April, these hedge funds jumped ship – and overnight, German bunds became "the short of a lifetime."
Hedge funds were dumping bonds and shorting them. No one else wanted to buy them, at these minuscule or negative yields.
This set off a rout during which €344 billion was lost on Eurozone-government bonds alone, according to Bloomberg, and with additional hefty losses on euro corporate bonds. As all this began to sink in, fund investors yanked nearly €2 billion from euro-bond funds in the past six weeks, the first major outflows in over a year.
"Bloody" as Odey had put it so eloquently.
The ECB rode to the rescue. This sort of turmoil went against everything it had tried to accomplish. So it announced that it would frontload some of its bond-buying spree ahead of the summer, under the pretext that this would avoid having to buy so much debt at a time when European market players would be on vacation and nothing could get done.
As far as the markets were concerned, the announcement meant an additional short-term mini-QE. It stopped the bleeding. Bonds recovered some, and yields settled down. By now, the German 10-year yield, after spiking from 0.05% to 0.77% during the weeks of turmoil, has dropped to 0.50%.
All this even though the ECB's QE has barely begun. But it shows how these bouts of QE around the globe have perverted asset pricing mechanisms. The markets front-run QE as rumors and suggestions of QE run wild, and they're driving up bonds and stocks in the hope of QE, as they have done in Europe, and when QE finally arrives as it did in March, stocks and bonds begin to sink. German stocks, for example, are down 7.4% from their peak in early April, after having shot up nearly 50% since October.
And so central bank jawboning, rumors of QE, suggestions of QE, promises of QE, and finally QE itself work in driving up markets – until someday, they don't. And that's when "unexpected" turmoil sets in.
Central banks think they're omnipotent – until they aren't.